When Congress finally turns its attention to tax reform later this year, it will confront a U.S. economy that looks dramatically different from the last time lawmakers pulled off a major rewrite of the code over 30 years ago.
In 1986, the year President Ronald Reagan signed reform legislation, most businesses were set up as traditional corporations and U.S. companies earned most of their income from sales inside the United States. That meant lawmakers didn’t have to worry too much about the difference between corporate and individual rates or the way foreign earnings were taxed.
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That’s no longer true.
Now the majority of businesses are structured as “pass-through” entities in which owners pay the regular income tax — often lower than the corporate tax — on their earnings. The U.S. has around 1 million fewer traditional “C corp” businesses than it had in 1986.
And unlike then, companies in the Standard & Poor’s 500-stock index now generate about half of their earnings from sales outside the United States. But the U.S. is an outlier among most developed countries as it still collects domestic taxes on income earned abroad, leading companies to park around $2.6 trillion abroad rather than face double taxation.
The rate of domestic investment in the U.S. is also about half what it was in 1986.
Those far-reaching economic changes have led to a bipartisan consensus that the U.S. corporate tax code is a broken mess, encouraging companies to game the system by nominally moving operations overseas and stashing cash offshore. But there is still widespread disagreement over exactly how the code should be changed, and given today’s hyper-partisan political environment, there is no guarantee changes will be made.
“There’s no question that the U.S. corporate tax code has to change, but the big difference between 1986 and now is that in 1986 you had a bipartisan effort,” said Megan Greene, chief economist at Manulife, a financial services group. “Now you don’t have that. The most important difference this time around is political.”
Even many Democratic economists agree that a rewrite of the corporate tax code is badly needed. But they disagree with Republican hopes to get the corporate rate as low as 15 percent — the current top federal rate is 35 percent — and they want guarantees that if corporations are allowed to bring money back from abroad at a lower rate, they will use the money to invest rather than simply pass it back to shareholders through stock buybacks and dividends.
They also want to be sure that tax cuts for corporations do not add to deficits.
“The priority today needs to be to lower the statutory rate on C corporations, fix the taxation of international income, and do this in a manner that does not increase the deficit,” said Jason Furman, a Harvard professor who was chairman of the Council of Economic Advisers under President Barack Obama.
Republicans could theoretically pass a tax reform bill on purely partisan lines. But the party disagrees internally on how this should be done.
Leaders in the House want a deficit-neutral plan and had pressed for a border tax that could generate over $1 trillion in revenue over 10 years and potentially encourage domestic production. But Senate leaders and the White House rejected that plan so it’s been tossed aside, leading to a scramble to come up with other revenue sources or resort to passing supply-side tax cuts that add to the deficit and may have to expire.
A temporary plan could wind up making matters even worse, analysts say. It would not give businesses certainty over their long-term tax burdens, something necessary to create the kind of increase in investments that could boost jobs, wages and economic growth. It could also fail to address another big change in the economy since 1986: the reduction in savings and investment.
According to data from the Tax Foundation, domestic investment accounted for 10.4 percent of net domestic product in 1986. In 2016, it accounted for just 4.8 percent. This is why many economists argue that perhaps the most important part of any tax reform package would be allowing companies to more quickly deduct the cost of new capital investments, so-called immediate expensing.
“The issue of lagging private investment, especially since the Great Recession, but more generally is at the forefront of a lot of lawmakers’ minds,” said Scott Greenberg, senior analyst at the Tax Foundation. “Greatly reducing the cost of capital would indeed encourage businesses to invest more and expand. This wasn’t as urgent in the 1980s when investment levels were higher.”
The problem here, as with everything else in tax reform, is that moving to immediate expensing would cost tax revenue and could threaten cherished deductions enjoyed by individual industries.
Real estate and private equity firms, and others who rely heavily on debt, for instance, are strongly protective of the corporate interest deduction currently in the tax code, and which House Republicans want to eliminate. In the end, immediate expensing may get left out, but some form of accelerated cost recovery remains in the discussion.
Lawmakers are also focused on addressing the issue of pass-throughs. Lowering the corporate rate alone would have limited impact. In 1986, 71 percent of business income came through traditional C corps and 29 percent from pass-throughs. In 2012, 40 percent came through C corps and 60 percent from pass-throughs.
The shift occurred due to the generally high corporate rate and the fact that corporate income is taxed twice — once at the company level and again on investors through capital gains and dividends taxes.
House Speaker Paul Ryan addressed this issue in recent remarks on tax reform.
“You can’t just lower the rate for corporations, which is in America 20 percent, 10 percent in Wisconsin,” he said. “You have to lower the rates for everybody across the board.”
White House National Economic Council Director Gary Cohn is spending a good deal of his time trying to figure out what to do about pass-throughs. “We’ve gotten an enormous amount of feedback in the pass-through space,” Cohn said at a White House meeting recently. “We still haven’t figured out what exactly to do with pass-throughs.”
It’s also on the minds of members of Congress.
“The sizable pass-through community can’t be left out of the process,” said Rep. Vern Buchanan (R-Fla.), who has a bill to equalize tax rates for pass-throughs and corporations. In the private sector, he ran a corporate business that he ultimately reorganized as a pass-through.
“You restructure these companies, partly because the tax code changes and your lawyers and CPAs say this makes more sense,” said Buchanan, a member of the Ways and Means Committee. “You can’t have corporations and pass-throughs competing in the same industries here and abroad and at that much of a disadvantage on rates. It just makes no sense.”
But the pass-through issue again leads to partisan disputes.
Democrats are strongly opposed to Trump’s proposal to apply a 15 percent rate to both traditional corporations and pass-throughs, arguing it would be a massive tax cut for wealthy individuals and would create significant tax avoidance among those seeking to reclassify non-business wage income as pass-through income.
The administration has suggested it would come up with ways to make it harder for individuals to game the system but has yet to offer specifics. Existing proposals to address the problem are all complex and fraught with potential problems, according to Greenberg.
“All this means that when lawmakers are thinking about tax reform they are essentially having to juggle two separate tax codes at once,” Greenberg said. “And any kind of reform bill will have to be a complicated balancing act of how best to approach both types of business form. It’s a hard phenomenon to deal with.”
Despite the internal fighting, Republicans in Congress remain convinced that modernizing the tax code would lead to better standing for the U.S. in an economy that’s far more global in nature than three decades ago.
Numerous other countries have cut tax rates — particularly for businesses — and amended their tax laws in other ways since the last major tax code revision in the U.S. With the situation relatively static stateside, many companies have looked abroad in the meantime and have either moved, inverted or been acquired by foreign competitors.
Lawmakers believe that reversing this trend is key to unlocking stronger economic growth in the U.S. and all that comes with a more robust expansion, such as a rise in jobs, earnings, productivity, investment and federal debt.
“We want to try to get economic growth back to the level that it used to be,” said Rep. Pat Tiberi (R-Ohio), another Ways and Means member. “We’ve been bumbling along the bottom of the barrel now for 10 years.”